Christine Benz: Hi. I'm Christine Benz for Morningstar.com. Morningstar launched its nontraditional bond category this week. Here to discuss what kinds of funds fall into this category is Eric Jacobson. He is director of fixed-income research with Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Great. Thanks for having me, Christine.

Benz: So, Eric, this is a brand new category. I'd like to discuss the types of funds that you're putting into this category, and where they came from. Where were we housing them before we created "nontraditional bond."

Jacobson: Sure. Well, I think of these funds, most of them, in fact, as a subset of what we would otherwise call multisector bond. There's been some confusion about this, because I think some people think that we were either miscategorizing them or we really didn't have anywhere to put them. The second part is somewhat accurate, but for the most part, they would fall under multisector bond. They're just a really small subset.

What we've done here is, we decided that we've got enough of them to break them out as a relatively unique category. Even though there's some room for slippage in the name, nontraditional bond in and of itself is a little bit deliberately vague.

Benz: So, you and I have talked about the unconstrained bond funds that we've seen cropping up. They're going into this category, but also a few other types of funds. Absolute return is another group. And I'm wondering if you can discuss what that is, and whether it's possible for funds to consistently deliver on that promise of absolute return, given that there are very few sure things in the way of returns or yield these days.

Jacobson: Sure, and I'll go ahead and take the second part first and work my way back. So, the concept of absolute return is sort of more a theory than a practice in some cases, in that the idea is to try and generate as much "absolute return," but really what they're saying is "positive" return, without the negative consequences of investing.

So, the idea is to use shorting strategies in some cases, balancing things out with cash--whatever they can do to eliminate the kind of volatility that's going to wind up with losses. And that in and of itself is a pretty heady thing to go after. It's not the kind of thing that's been well proven in the investment universe, but there are obviously people out there trying to do it, in large part because there's a tremendous demand for it. And as you mentioned, there is a subset of funds that are essentially marketing themselves as such and trying to achieve that.

Benz: Well, let's look into that. How have they done so far in general? The funds that are billing themselves as absolute return, have they been able to deliver on that promise so far?

Jacobson: Well, I think, part of the question is how you define success. So, there are some funds, for example, that flat out haven't succeeded because they had some losses that people probably wouldn't tolerate. But the more common occurrence, really, is that they haven't been able to meet their aspirations for positive return, because, for example, some of them give their buyers a target that they're trying to achieve. Putnam has done that with some of their absolute return funds. They've shifted the benchmark a little bit.

I don't think that they've been necessarily an abject failure per se, but they haven't necessarily lived up to what they're going after with some of their shorter funds, if you will, some of the less volatile targeting funds that they have, like the Absolute Return 100 and the Absolute Return 300.

As I understand it, at least the 100 is not probably likely to make its mark by the end of the year, but we'll see how things go.

Benz: So what is that 100 and 300 mean in this context?

Jacobson: Great question, because I think that may be a question for a lot of people. And that is, essentially 100 basis points or 1% per year is a targeted return, or 3 percentage points per year with a targeted return. And the idea being that they're going to try and achieve that with very minimal volatility and hopefully no big losses along the way.

They have a little bit more opportunity to do that with those shorter types of portfolios if they want to be very, very cautious, but it's still not that easy to do.

Benz: Why would the 100 Fund not be able to beat or to meet its expectations?

Jacobson: Well, because if nothing else, the environment we're living in right now where short-term rates are so incredibly low that the usual things that you could use to generate an easy amount of return there just aren't quite as available, because fed funds is next to zero. Money markets aren't returning almost anything. And you've got to take some kind of risk, essentially, to even break 1% on a consistent basis without the risk of principal loss.

Benz: So, let's get back to unconstrained. That's another growing category that falls under this nontraditional bond umbrella. Discuss broadly, Eric, what unconstrained bond funds are?

Jacobson: Sure. Let me put the caveat out there that they're not as different as I think a lot of people believe they are. We've had a lot of questions about this already, but I'll go ahead and explain.

The idea, generally speaking, behind unconstrained bond is to give the manager a tremendous amount of freedom. So he or she can take a lot of interest rate risk if they feel that the market presents an opportunity, or to not only perhaps take no interest rate risk, but even take negative risk, so to speak. In other words, shorting the market so much that if interest rates fall and most bond funds are gaining, a fund like this would go the other way and vice versa. So, that if interest rates rise, in theory, they would make money.

Just to use it as an example, PIMCO Unconstrained has a duration range that runs from minus three years to positive eight years, and in theory the idea is the manager can go all the way across that spectrum depending on what he believes is going to happen in the interest rate market.

The other part of most of their strategies is that they have a tremendous amount of flexibility in terms of sectors as well, both domestically and globally. So, they may have emerging-markets bonds. They may have non-dollar developed-markets bonds, high yield. Pretty much anything you could think of that's a normal place for a multisector fund to go these days, you can find it potentially in an unconstrained bond fund.

Benz: I would like to discuss with you, Eric, the long-short funds or funds that are using shorting strategies within this group. How prevalent is that?

Jacobson: Well, let me say that there are a handful of those, but before we segue, I'd just like to say that they do some of that in the unconstrained space. One of the things I wanted to cap off there was that many of those [unconstrained funds], because of the fact that they are competing in this absolute return space and the fact that people are coming to them to beat back that interest rate volatility, are acting a lot like absolute return funds.

The reason that that's kind of a segue into your long-short question is, this long-short activity is going on across the board. You're seeing it in all the funds pretty much in this category. Some of them are much more distinct in the fact that that's part of their name and that's what they consider themselves to be. Sometimes long-short is another way of saying market neutral, depending on the marketing scheme that they're using. But there are just a handful of those that are kind of taking over from the hedge fund space, where really what they are trying to do, for example, is get all of the systematic risk out of the position by going long on a particular individual credit whether or not by using bonds or default swaps, and then shorting it perhaps with another default swap, for example--that's a whole market-based default swap, take out the market risk and just try and achieve what they belief is the extra return potential of just getting exposure to that one name without, for example, taking on the risk of the entire credit market.

Benz: Okay. So, Eric it sounds like a very broad basket, a lot of different strategies going on here in this nontraditional bond category. If people are looking at some of these funds, how should they think about using them in a portfolio? I am thinking you will probably say "it depends," but I'm wondering if you can give any more guidance there.

Jacobson: Well, I do think that, for starters, it's safe to say, we haven't really seen a case to be made that you should be using them to replace any kind of core position. I think that's important, because I think a lot of the marketing is suggesting to people that that's really what they ought to be doing. I think that's what people are looking for as well.

Unfortunately, there is not going to be a free lunch, and you may miss out on things even if you don't get hurt too badly. So you and I have talked about some of these funds where the promises seem to be a lot greater than what they have delivered so far. By and large, I would say, if you are interested in one, or a handful of them, try and get to know them really, really well, because unfortunately even what they say in the prospectus in terms of what they can do may not really match a lot in terms of what they have done so far.

A number of them, for example, these unconstrained funds, have much broader mandates than what they have actually done. They have been a lot less volatile, a lot shorter, which is fine in some cases, but they may have also missed out on the big rally this summer, for example.

Benz: So, when you are saying get to know them, I assume that means really taking a look at what's in their portfolios, looking at their performance patterns--how do they do in strong bond markets, weak bond markets, and so forth?

Jacobson: Exactly. I encourage people to use our resources and what we write up here at Morningstar, but the good news is that because some of these funds are pretty new and they are coming to exist in a world where information is much more freely flowing, some of them tend to do a better job than others in terms of releasing information, and at least making it under somewhat understandable what they are holding.

I would say that applies for the JPMorgan Fund, JPMorgan Strategic Income Opportunities. I think PIMCO and Harbor, which is PIMCO Unconstrained and Harbor Unconstrained, are doing a better job than they had before. And I think the others are starting to catch up as well. I mention these because they tend to be some of the largest, most popular funds. They have conference calls, either every month or every quarter. I would really say that someone who really wants to dig in and make sure they understand them can avail themselves to some of those same things as well.

Benz: Last question for you Eric. Any standouts, any favorite funds? I know its early days for most of these funds, but I am wondering if you've got any favorites.

Jacobson: I really don't at this point. I've mentioned a couple here that we follow pretty closely, largely because of their size. I think a lot of the managers; I think that Chris Dialynas at PIMCO is a very long-tenured, skilled, experienced manager. I think, Bill Eigen has a lot to show for himself at JPMorgan. But the formats of these funds have yet to really prove themselves in a way that is enough for us to say, "Yes, we recommend that. We think you should be buying these."

So really what we are trying to do right now is help people understand them as best they can and suggest that they be pretty careful.

Benz: Okay, Eric. Thank you. It's always terrific to hear your insights. Thank you so much for being here.

Financial planner Mark Balasa and Morningstar's ChristineBenz and David Blanchett tackled viewers' most pressing retirement questions, from determining savings rates and income needs to planning for Social Security and maximizing retirement accounts.

Morningstar's EricJacobson comments on 2011's long -term Treasury rally, fund managers' current perspectives on government debt, PIMCO Total Return's current positioning, remaining opportunities in munis, and top considerations for fixed-income investors today.

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